2020-0853571C6 2020 IFA Conference CRA Roundtable Q #7

Principal Issues: Whether a Canadian corporation (Canco1) is eligible to make an election under paragraph 5901(2)(b) of the Regulations in respect of a dividend paid to it by a foreign affiliate of Canco1 (FA) on a particular class of shares when a separate class of shares of FA is owned by a partnership (LP).

Position: Yes.

Reasons: Textual, contextual and purposive interpretation of paragraph 5901(2)(b) of the Regulations.

Author: Eroff, Ina
Section: Regulation 5901(2)(b)

2020 International Fiscal Association Conference

CRA Roundtable

Question 7- Regulation 5901(2)(b) Pre-Acquisition Surplus Election

Provided that the requirements of paragraph 5901(2)(b) of the Income Tax Regulations (the Regulations) are met, an election (Regulation 5901(2)(b) election) may be filed by a corporation resident in Canada to “side step” the normal surplus ordering rules and treat a particular dividend paid by a foreign affiliate of that corporation as having been paid out of the pre-acquisition surplus of the affiliate in respect of the corporation. One of the requirements, as provided for in subparagraph 5901(2)(b)(ii) of the Regulations, is that no shareholder of the affiliate is, at the time of the dividend, a partnership a member of which is either “a” corporation that would, in the absence of subparagraph 5901(2)(b)(ii) of the Regulations, be eligible to elect under subparagraph 5901(2)(b)(i) of the Regulations in respect of the particular dividend, or a foreign affiliate of such a corporation.

Assumed Facts

* A foreign affiliate (FA) of a corporation resident in Canada (Canco1) has issued and outstanding Class A common shares and Class B common shares.

* Canco1 owns 100% of the Class A shares and a limited partnership (LP) owns 100% of the Class B shares.

* One (or more) of the members of LP is a corporation resident in Canada (Canco2) that has a sufficient partnership interest in LP such that FA is considered to be a foreign affiliate of that corporation as defined under subsection 95(1) of the Income Tax Act (Act) for the purposes described in subsection 93.1(1.1) of the Act. None of the members of LP is Canco1, a foreign affiliate of Canco1, or a corporation resident in Canada that is related to Canco1 (or a foreign affiliate of such a corporation).

* FA pays a dividend to Canco1 in respect of the Class A shares of FA (Class A dividend) that absent paragraph 5901(2)(b) of the Regulations would be deemed under subsection 5901(1) of

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the Regulations to have been paid out of the exempt surplus, hybrid surplus or taxable surplus of FA in respect of Canco1 and in respect of Canco2.

* Canco1 will not make an election under subsection 90(3) of the Act in respect of the Class A dividend.

* Canco1 wishes to elect under subparagraph 5901(2)(b)(i) of the Regulations for the Class A dividend to be treated as having been paid out of FA’s pre-acquisition surplus in respect of Canco1.

Is the CRA of the view that the requirement imposed by subparagraph 5901(2)(b)(ii) of the Regulations that no member of LP be eligible to elect under subparagraph 5901(2)(b)(i) of the Regulations would be met in these circumstances such that Canco1 is eligible to make a valid Regulation 5901(2)(b) election in respect of the Class A dividend?

Would the CRA’s view change if FA only had a single class of issued and outstanding shares and paid a dividend to both Canco1 and LP?

CRA Response

In the Assumed Facts, whether Canco1 can elect under paragraph 5901(2)(b) of the Regulations in respect of the Class A dividend to deem that dividend to have been paid out of the pre-acquisition surplus of FA in respect of the corporation turns on the interpretation of clause 5901(2)(b)(ii)(A) of the Regulations. In particular, that determination turns on whether Canco2 is a corporation that would, in the absence of subparagraph 5901(2)(b)(ii) of the Regulations, be eligible to make a Regulation 5901(2)(b) election in respect of the Class A dividend.

The interpretation of paragraph 5901(2)(b) of the Regulations needs to be made according to a textual, contextual and purposive analysis to find a meaning that is harmonious with the Act as a whole.

With respect to the Regulation 5901(2)(b) election, the October 24, 2012 Technical Notes issued by the Department of Finance indicate the intention for shareholders to have the ability to access their adjusted cost base (ACB) first:

“This election is meant to allow the shareholders of a foreign affiliate to access their capital first as measured by the adjusted cost base (“ACB”) of the shares rather than a legal notion of paid-up capital.”

If a corporation resident in Canada or its foreign affiliate receives a dividend from a foreign affiliate that is prescribed to be a pre-acquisition surplus dividend in respect of the corporation, the corporation or the recipient affiliate (as the case may be) is required to reduce its ACB of the relevant shares of the foreign affiliate that paid the dividend.

Even though the preamble of paragraph 5901(2)(b) of the Regulations does not specify to whom the “whole dividend” referred to in this paragraph is paid by the foreign affiliate, it is our view that, when paragraph 5901(2)(b) of the Regulations is interpreted based on a contextual and purposive analysis of this provision, the “whole dividend” referred to in the preamble is a reference to a dividend that would cause a consequential ACB adjustment to the shares of the foreign affiliate on which it is paid, if a Regulation 5901(2)(b) election could be made in respect of that dividend.

In the Assumed Facts, if Canco2 was entitled to make a Regulation 5901(2)(b) election in respect of the Class A dividend, there would be no consequential ACB adjustments with respect to Canco2 or LP since neither Canco2 nor LP owns any Class A shares. On that basis, we are of the view that the Class A dividend is not a “whole dividend” as referred to in the preamble of paragraph 5901(2)(b) on which Canco2 would be eligible to make a Regulation 5901(2)(b) election, even in the absence of subparagraph 5901(2)(b)(ii) of the Regulations. As such, with respect to the Class A dividend, the condition of subparagraph 5901(2)(b)(ii) of the Regulations would be met, with the result that Canco1 could make the Regulation 5901(2)(b) election.

Limiting the exclusion in subparagraph 5901(2)(b)(ii) of the Regulations as explained above is, in our view, consistent with the legislative intent of this subparagraph. As indicated in the October 24, 2012 Technical Notes to paragraph 5901(2)(b):

“There are some circumstances in which this new pre-acquisition surplus election is not available. First, because of the special deferred treatment given to pre-acquisition surplus dividends paid on foreign affiliate shares held by a partnership (as per subsections 92(4) to (6) of the Act), this new election is not available where any electing corporation (as described in subparagraph 5901(2)(b)(i)), or a foreign affiliate of such a corporation, is a member of a partnership and that partnership is a shareholder of the dividend-paying foreign affiliate. […]”

We would not reach the same conclusion if the Assumed Facts were changed such that FA only had one class of shares issued and outstanding, and LP owned a portion of those shares and received a portion of the dividend paid by FA. It is our view that in these circumstances Canco2 would, in the absence of subparagraph 5901(2)(b)(ii) of the Regulations, be eligible to make a Regulation 5901(2)(b) election in respect of the dividend. Since Canco2 would be “a corporation” referred to in clause 5901(2)(b)(ii)(A) of the Regulations, it is our view that in these circumstances the condition of clause 5901(2)(b)(ii)(A) would not be met, with the result that neither Canco1 nor Canco2 would be eligible to make a Regulation 5901(2)(b) election.

John Meek/Ina Eroff
September 15, 2020
2020-085357

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